A trader\'s money management system

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76 A TRADER’S MONEY MANAGEMENT SYSTEM

chance of going completely bankrupt. The ROR mathematical formula is

based on three components:

1. Win ratio.This is based on your percentage of wins and your proba-
   bility of winning. For example, if your win ratio is 40 percent, you have
   40 percent wining trades and 60 percent losing trades.


2. Payoff ratio.Average winning trade dollar amount divided by the av-
   erage losing trade dollar amount. This is how many dollars you earn
   compared to one dollar lost—for example, 3 to 1 would mean you earn
   three dollars for every one dollar you lose.


3. Percent of capital exposed to trading.If you are a novice trader it
   is recommended that you risk no more than 2 percent of your trading
   account value on any one trade. Otherwise, you can determine the op-
   timal percent of capital to risk by either referring to a risk-of-ruin table
   (see Nauzer Balsara’s book,Money Management Strategies for Fu-
   tures Traders,or Tushar Chande’s book,Beyond Technical Analysis,
   2nd ed.) or by using the optimalfformula in this chapter.

Your trading system design and your skills as a trader govern the first

two items in the risk of ruin, and your money management system controls

the third item. The risk of ruin potential decreases as the payoff ratio in-

creases or the probability of winning increases. The larger the percent of

capital risked on each trade, the higher the chances for risk of ruin.

IMPORTANT NOTE: For some advanced traders, it is beneficial to

risk more than 2 percent of their trading account. The amount these

traders risk must be carefully calculated depending on their proven

historical performance statistics. See the formulas in this chapter to

determine if your payoff ratio and win ratio performance warrant a

higher risk than 2 percent.

For our purposes, we are assuming that you already have a system that

gives you an edge and provides you with a payoff ratio that is better than

1 to 1. You can estimate what your probabilities of ruin are by identifying

what your payoff ratio and win ratio are and by referring to the risk-of-ruin

tables found in Tushar Chande’s book and also Nauzer Balsara’s:

Tushar Chande,Beyond Technical Analysis, 2nd ed., John Wiley &

Sons, 2001, has the following risk-of-ruin tables:

1 percent capital at risk


1.5 percent capital at risk


2 percent capital at risk